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Having to pay capital gains on U.S. stocks may seem unfair but if the loonie recovers, the situation reverses.Melissa King/Getty Images/iStockphoto

Recently, I heard from a reader who was trying to decide whether to sell his McDonald's shares. He was concerned that, because the loonie had plunged, he would have to pay additional capital-gains tax related to the currency gains even though he planned to leave the proceeds in U.S. dollars to pay for travel down south. That struck him as unfair.

Today, I'll look at the reader's example in detail, because it illustrates a dilemma many Canadian investors are facing. It also points to a common error that investors make when calculating capital gains and losses on foreign securities. (Note: This discussion only applies to shares held in a non-registered – i.e. taxable – account.)

The reader, whom I'll call Dave, bought McDonald's shares several years ago, when the Canadian dollar was at par with U.S. dollar and when the burger chain was trading at $75 (U.S.). Since then, the loonie has plunged to about 72 cents and McDonald's has climbed to about $116 (I'm using round numbers to make things easy).

By Dave's reckoning, if he were to sell McDonald's, his capital gain for tax purposes would be $56.94 (Canadian) a share. He arrived at this figure by calculating his gain in U.S. dollars – which is $41 (U.S.), or $116 minus $75 – and then converting that number to Canadian dollars by dividing it by the current exchange rate of $0.72 per $1 (Canadian).

John Waters, head of tax and estate planning with BMO Nesbitt Burns, sees many advisers and clients calculating capital gains on U.S. stocks the same way Dave did. But it's incorrect. "That's what most people would do. Most people would assume that they would calculate their gain or loss in U.S. dollars and convert that at today's exchange rate into Canadian dollars," he said.

When the calculation is done the correct way – as we'll see in a moment – Dave's capital gain is actually much larger than he thought.

The first step is to figure out Dave's adjusted cost base (ACB) in Canadian dollars. Because the loonie was trading at par when he bought his McDonald's shares, his $75 (U.S.) cost per share was simply $75 (Canadian). Dave can also add the cost of his commissions, in Canadian dollars, to the ACB, but we'll ignore them here.

The next step is to figure out the value of the sale proceeds, also in Canadian dollars. This is determined by dividing the sale price of $116 (U.S.) by the current exchange rate of $0.72 (U.S.) per $1 (Canadian), which works out to $161.11 (Canadian). Commissions can be subtracted from the sale proceeds, but we'll ignore those as well.

Now, we're ready to calculate Dave's capital gain, in Canadian dollars, if he were to sell today. It is the sale proceeds of $161.11 minus the ACB of $75, or $86.11. Unfortunately for Dave, that's about 51 per cent higher than he originally thought.

The fact that Dave plans to leave the proceeds of his McDonald's sale in U.S. dollars doesn't matter: He still has to pay tax as if he had converted the cash to loonies.

That may seem unfair. After all, if Dave leaves his cash in greenbacks to spend while he's travelling in the United States, he's not really benefiting from the loonie's tumble. One can even conceive of a scenario in which a Canadian investor purchases a U.S. stock that flatlines for years; the investor doesn't make any money at all in U.S. dollars, but he or she might still have to pay capital-gains tax if the Canadian dollar falls.

Mr. Waters says it's not as unfair as it seems. For example, if Dave decides to sell his McDonald's shares and then reinvests his cash in a different U.S. stock, his ACB in Canadian dollars will be inflated by the loonie's current depressed value. If the loonie then recovers, his ultimate capital gain in Canadian dollars will be lower than it otherwise would be. So currencies work both ways.

"Right now, everybody's crying the blues because they've got these big gains that they're reporting and paying tax on, but if the Canadian dollar starts appreciating, then it will be going the other way and you'll get the benefit of those [currency] losses," Mr. Waters said.

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